Blue Bull, Inc., has a target debt-equity ratio of .88. Its WACC is 8.7 percent,

ID: 2715229 • Letter: B

Question

Blue Bull, Inc., has a target debt-equity ratio of .88. Its WACC is 8.7 percent, and the tax rate is 38 percent.

If the company’s cost of equity is 12.8 percent, what is its pretax cost of debt?

If the aftertax cost of debt is 5.4 percent, what is the cost of equity?

Blue Bull, Inc., has a target debt-equity ratio of .88. Its WACC is 8.7 percent, and the tax rate is 38 percent.

Required: (a)

If the company’s cost of equity is 12.8 percent, what is its pretax cost of debt?

(b)

If the aftertax cost of debt is 5.4 percent, what is the cost of equity?

WACC = Wd×Rd×(1-t)+ We×Ke

W is weights of respective portfolios

R is return on respective portfolios

8.7% = (0.88÷1.88)×Rd×(1-38%)+ (1÷1.88)×12.8%

8.7% = 0.29×Rd+6.81%

Pre-tax cost of debt, Rd = 6.5%

8.7% = (0.88÷1.88)×5.4%+ (1÷1.88)×Ke

Cost of equity, Ke = 11.6%

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